The Ultimate Value Trap:

byBrad FerrisonJuly 8, 2008

One of the lessons I learnt as a young value pupil was to take note of my surroundings and learn to view investing with a slightly different perspective. One lesson taught to me by Charles was an insight that an investor is often “far too eager to discuss their investing successes than they ever will be in talking about their failures” and this should serve as an important lesson for where my investing education should build its foundation. For as all the individual successes I’ve studied of various investors I’ve examined a greater amount which have failed. It’s easy to label Warren Buffett as the most successful investor of all time, but very few of ever consider or study his mistakes and what we can learn from them.

My Value Rules serve as a reminder of all the successes and failures that I’ve studied, learnt from and experienced in business. While they don’t guarantee success they serve as a template and instructional tool for evaluating an investment from a number of different perspectives. In my Taking Stock inTM series I discuss companies that I invest in that hold a number of value criteria or Enduring Value characteristics. These posts might be a great teaching tool for readers about investing, but do they help identify companies that are of less or no value? What would a post in that series look like if I analyzed a company that I wouldn’t invest in? I discuss the impact of competitive advantages for companies, but what about a competitive disadvantage?

My post today is to discuss my pick for The Ultimate Value Trap: General Motors (GM).

It’s no surprise that in recent years GM has had some difficulties in a number of areas…well, a lot of areas. When you examine the company not only is a value stimulus difficult to find – it’s possible that none exists. Well I won’t speculate on the recent rumours of potential bankruptcy there is amble evidence at this time that the company is in some serious trouble.

When I examine investor activity in GM over the past four years I encounter what I like to call a Value Investor Casualty List. The list includes a number of value oriented investors who currently hold or have held GM shares in the past few years.

The most dedicated of these value investors was Irwin Michael who held 360,000 shares in three of his ABC Funds at an average cost of $56.95 per share. After a loss of over 80% on the original value invested in the company it was shared with fundholders on July 4th that ABC had liquidated all of its shares of GM that were held in the three funds. Other investors who have been burned badly on GM include David Dreman, Dodge & Cox, Brandes Investment Partners, Kirk Kerkorian and Bill Miller of Legg Mason Capital Management.

Investors know that GM has obliterated billions in market capitalization, that its shares currently trade near fifty year lows or that the number of manufacturing jobs that GM has cut or indirectly caused is in the tens of thousands. But I’ll take a different route and look at the qualitative side as I go through a brief history on GM to identify what warning signals should have been appearing to investors as the troubles began to brew.

It should be no surprise to an investor that GM has a history of missteps by management, massive pension obligations to its retirees, an expensive workforce, far-sighted union leadership and too much inventory. Still many value investors were seduced by a high dividend yield in a company with consistent payouts, low P/E and P/B ratios, a long-standing member of the Dow Jones 30 and operating within an industry that provided predictable cyclicality. With 15% global market share as the largest automotive manufacturer in the world investors saw the competitive forces at work and made assumptions that earnings growth would return as the financing division of the company (GMAC) performed well by providing consistent earnings over the interim. Add that the company’s CEO Rick Wagoner was buying shares and the stock looked to be mis-priced and undervalued. But remember back to how I organize my information on a stock: the situational analysis: SWOT & PEST.

What’s missing? What important or unseen factors have been overlooked or ignored?

Whether intended or not it appeared that no one recognized or heavily discounted some tragic flaws in GM. For years the company had been paying its unionized employees wages and benefits well above what would turn out to be competitive and realistic levels. Through various negotiating means union leaders created an ability to collectively wrestle the Big 3 into lucrative union packages where no one bothered to compare wage levels with those of similarly qualified workers in industries such as healthcare, education or other manufacturing sectors.

In 2005 came what the market generally expected with the rating cut by Standard & Poor’s of GM’s corporate debt, over $300B worth, to junk status. S&P at the time made the following comment, “The downgrade to non-investment-grade reflects our conclusion that management’s strategies may be ineffective in addressing GM’s competitive disadvantages.” By 2006 investors watched diligently as management cut the dividend by 50% (its first since 1993), cut benefits of salaried workers and made cuts to executive pay including trimming Wagner’s annual wage by half. In Q4 of 2006 profitability returned to the company, the shares appreciated more than 35% from their February low and reached a high of $42 in late 2007 despite some moderate write downs. Through all of this investors had missed some of the most crucial flaws of the company: managements’ inability to address the most pressing issues.

For years GM and its employees had enjoyed the benefits of high demand for its even higher margin SUV products and the impact from the US housing collapse and later credit crisis was finally felt and brought GMAC down to its knees. For too long GM’s management had been swimming without any clothes on and when the tide went out, as Buffett might say, it wasn’t a pretty picture. GM went to the UAW & CAW and got concessions for a two-tier wage structure that would drastically decrease their costs of labour and created a UAW controlled VEBA that took $51B of retiree medical benefits off GM’s books in addition to offering a staggering number of buyouts to many of its senior unionized employees.

After all of these events investors are still left asking themselves, “Does GM offer value today?” GM currently trades at a yield that hovers near 10% (assuming there’s no cut), trades at a significant discount to its value a few short years ago and at some point an investor might assume that its assets that are worth something. The difficulty of looking at a company like GM is that it still feels like a Value Trap even after already catching a number of investors. GM has now taken drastic measures with plant closures, more buyouts of employees and reorganization of their retiree obligations to cut costs, but will it be enough?

To put all this into a better perspective (The Big Picture) let’s look to just 4 of my Value Rules for some insight into why I wouldn’t invest in this company:
– Importance of Brands
– Do What You Do Best
– Strategic Management
– Never Compete on Price

In the past decade GM has sold automobiles under the brand names of Buick, Cadillac, Chevrolet, Daewoo, GMC, Holden, Hummer, Oldsmobile, Opel, Pontiac, Vauxhall, Saab, Saturn…Neptune…Pluto…get the point? Not only are there too many product lines in this company, but there’s overlap and duplication that borders on insanity; it simply doesn’t make economical sense. The Silverado & Sierra are the same vehicle. The Yukon & Tahoe are the same vehicle. The Solstice & Sky, Cobalt & G5, etc, etc are all the same vehicles. The only differences between them are a few changes to the trim, logos, interior, options and where they’re sold. Instead of doing one or two things as best as the company can it’s done a lot of everything and lacks a core focus.

The core focus for GM’s management is best defined by three letters: S, U & V. For years now GM has gotten fat on the SUV and its manufacturing infrastructure is largely built on high margin, large framed vehicles. They’ve developed little in the way of innovative products that consumers want and have done an even poorer job of forecasting future consumer demand and perceptions. They do sell a lot of vehicles, but they also run on a very dangerous structure of competing on price. We’ve been here before but to summarize there are few serious problems with this approach. Once consumers get in habit of getting cheap they expect cheap or want cheaper. Consumers to some degree make comparisons among similar products and can associate quality with a product or service of a slightly higher price. When you compete on price and you’re competition can make the same product cheaper you’re dead in the water. Your competition will simply match your price, get fat off their higher margins, wait to take you out for next to nothing or let you self-destruct.

To make a comparison Toyota, GM’s top competitor, has only two brands: Toyota and Lexus. In each product category the brands have only one product offering and management focuses intently on consumer needs, demands and expectations for each product. Toyota spends a lot of time on market research, connecting with customers and its repeat purchases from existing Toyota customers are top in the industry. Walk onto any Toyota lot today with the expectation of them competing on price and you’ll be quickly disappointed. Toyota doesn’t want to compete on price because it doesn’t have to. A company still has to remain competitive, but Toyota’s products are in high demand, they have limited excess supply and the cost of their workforce is a fraction of their competitors in GM, Ford and Chrysler.

When you’re a lower cost producer and the competition decides to compete on price your margins will speak for themselves. Not only is Toyota gaining market share but they’re making money, investing in their infrastructure and making inroads into product categories that have been dominated by the big 3 for decades. Add in high energy prices and consumer demand for more fuel efficient vehicles and the comparison quickly tips in Toyota’s favour. While GM closes plants Toyota continues to open more. When GM makes cuts to its R&D Toyota expands with new product designs and technologies to meet higher demand. If product quality, price and all other comparisons are equal Toyota will come out ahead based on its ability to make money and its positioning.

General Motors might appreciate significantly from here and an investor might assume that at this valuation the risk/reward premium is heavily weighted in their favour. But I would encourage any investor looking to invest into a troubled company to consider a few of the points I made in this post and to ask themselves if any of them apply. History does repeat itself and there are always exceptions, but generally in business you’ll find that managers run into corners more often than you realize.